Tulip Mania – and the Economic Bubbles

According to top financial bodies most of the world has recovered from the 2008 financial crises. Born in 1990s I have been un-lucky enough to witness at least two “Economic Bubbles” bursting: the “Dot Com” bubble of 2000 and the “Sub Prime” bubble of 2008. I don’t particularly remember 2000s as I was only 10 then, and was more concerned about Mario and Sonic, than the online companies failing. But I, clearly remember the 2008’s crises. There was a certain chill in the looks of the trader’s faces on the Wall Street as I saw them half a world apart on a TV screen. At that time I didn’t realise that the scared looks were the sign of a global disaster that had already happened. The traders and economists of America (more generally referred to as Wall Street), knew they had once again botched the job, at an enormous cost to the world.

I am a firm supporter of capitalism and free market, but this does not stop me from pointing out capitalism’s shortfalls. What exactly are these bubbles and why do they keep bursting? Let’s explore one of the earliest example of a bubble to understand them.

Definition of Economic Bubble:

A bubble is observed when any asset’s trading price, far exceeds its natural intrinsic value. Hence in literal sense, a bubble is value of an asset filled up with nothing but just air.

Dutch Tulip Mania of 1630s

It is crazy to think now that a pretty flower was the reason behind a major financial crisis. That’s exactly what happened in Netherlands. The story goes like this: The Dutch ambassador to the Ottoman Empire sent some tulips back home from Turkey and some were cultivated in Amsterdam. The people of Europe fell in love with the flower, which was different in style and beauty from the local species. Soon it became a status symbol to own fresh tulips. Certain species of tulip were even named some absurd titles like “Admiral” and “General”.

A tulip named “Viceroy”, that could sell for 4200 guilders. Source: Wikipedia- Tulip Book of P. Cos (Public)

As with all items of value, tulip bulbs also began to be traded in markets and became insanely expensive. At first these trades were normal farmer to buyer, but afterwards all kind of middlemen also jumped in. When flowers were not in season, traders began dealing in contracts to buy (essentially futures trade). So this meant a flower bud which was not even cultivated yet was sold and bought multiple times. The price of a single bud rose to as high as 4,200 guilders (see picture), as a comparison a skilled worker at that time, earned around 300 guilders per annum.

This inflated price of flowers, was bound to crash and that crash happened in February 1637. Buyers suddenly were not interested in buying flowers, mainly because they could not get outdoors because of the onset of bubonic plague. This was the point the bubble burst, a lot of people had highly inflated assets which suddenly had no value. Many people lost a lot of money.

Tulip Price Index, Source: Wikipedia-JayHenry (CC)

Sub-Prime Mortgage Bubble of 2008

A lot has been said about the reasons for the crisis in 2008, but the prime reason was that the loans (mortgages) on houses were valued at far higher value than the value of the houses they represented. This happened because traders speculated that house prices could only go up. So when the prices reached a certain level in 2007-2008, where no one was able to afford a house or give monthly mortgage payments, the bubble popped, leaving many financial giants and common people bankrupt.

House price history, Source: US Gov. (Public)

Bubbles Today

Experts have warned about some of the assets which “they” think are very inflated in value. These assets include tech start-ups and crypto-currency. It’s true that a large number of venture capital firms are paying very high amount funds to some start-ups that don’t rationally deserve to be valued at such high price. But again this is a brave new world of Facebook and Google, where Uber can get a valuation of US $70 Billion by just being a cab hailing service.

Recently Bitcoin (a crypto currency), has been under scrutiny for its huge jump in price. One Bitcoin was around US $650 last year in October, now it’s being traded at US $4906. Harvard economist Kenneth Rogoff, thinks that very soon Bitcoin bubble will pop.

Nobody knows for sure that what assets might become bubbles, but history has always thought us lessons, and here the lesson seem to be that, watch out when something goes insanely expensive.

Bitcoin Price Index, Source: bitcoincharts.com (CC)

Disclaimer: Author is not an economist, so any corrections would be welcome.